The Interest Rate Paradox

Last month, the Federal Reserve reduced its key interest rate, and the consensus suggested (and still suggests) that the Fed will cut rates two more times before the year ends.

A closely watched tool from the CME Group is pricing in a quarter-point rate cut at the November 7^th Fed meeting, and it favors another quarter-point rate cut at the December 18^th meeting.

Of course, there is no guarantee that this will happen, but if the Fed reduced the fed funds rate last month, and the consensus signals additional rate cuts are in the pipeline, why have bond yields started to back up?

The graphic below plots yields on Treasuries from 1 month to 30 years. The red line represents yields on September 18, the day the Federal Reserve reduced the fed funds rate. The blue line displays yields about 5 weeks later—October 24.

Yields are down for short-term T-bills: 1 – 4 months. In contrast, yields are up significantly across much of the curve (1 year to 30 years). So, what gives?

1. Bond investors are rethinking how aggressively the Fed will reduce interest rates. Talk of another half-percentage point cut in November is currently off the table. While odds favor a reduction in December, there is some chatter that the Fed could pause at the December meeting.
2. Economic resilience—job growth in September was much better than expected, according to Bloomberg News, and the prior two months were revised higher. Recent data reflect an economy that is performing admirably, while the jobless rate remains low. Consequently, aggressive rate cuts aren’t needed right now.
3. Large budget deficits translate into a greater supply of bonds that must be issued.

Consequently, investors have been re-pricing their outlook for bonds, surprising many who had expected yields to continue their decline or, at a minimum, stabilize near mid-September levels.

We may be having a completely different conversation later this year or early next year, as economic data can surprise either to the upside (as it is now) or disappoint. We’ll get a better read on Q3 on Wednesday when GDP is released. The October jobs report prints on Friday.

Happy Birthday

The bull market turned two years old last week. Since bottoming, the S&P 500 Index has climbed almost 64% (through 10/17/24). The index is up 22% from its early 2022 peak, according to data from the St. Louis Federal Reserve. Following the 2022 peak, the S&P 500 entered a nine-month bear market, shedding 25%.

But not all indexes are created equally. The Nasdaq takes top honors, as shown in the illustration above. The Nasdaq Composite is weighted toward technology firms, and the AI revolution has helped fuel outsized gains.

The S&P 500 Index takes second place. It is what’s called a market-capitalization-weighted index, which means the largest companies have an outsized influence over the index.

Since the start of the new bull market, the largest companies in the index have, on average, outperformed the smaller firms, contributing to the overall performance.

According to S&P Global, the top 10 stocks in the S&P 500 would be up about 100% over the last two years. They account for over 30% of the entire S&P 500 Index, according to Slickcharts.

The Dow Jones Industrial Average utilizes a different method. Still, it’s up a respectable 48%. Like the S&P 500, it has repeatedly set new highs this year.

While the rally has been concentrated in the larger companies, a measure that equally weights all S&P 500 companies has advanced a still-solid 42%, according to S&P Global.

Forces driving the bull market

The answer to the question is pretty simple: it’s the economic fundamentals.

While prices for goods and services are high, the rate of price hikes has slowed, which allowed the Federal Reserve to reduce the pace of rate hikes in late 2022 and into 2023.

You see, investors aren’t as concerned about the level of prices. Instead, they focus on the rate of change, and the rate of change has moderated significantly.

Eventually, the fed funds rate plateaued, and the Fed finally announced a rate cut last month. Moreover, the economy is still growing, which is supporting the growth of corporate profits.

In other words, the combination of stable/decreasing interest rates and profit growth is benefiting stocks.

Bear markets

Bear markets, defined as a 20% or greater decline in the S&P 500, have historically been associated with recessions.

Since the mid-1960s, only two bear markets have deviated from this historical pattern, according to St. Louis Federal Reserve data.

First, the one-day market crash of 1987, which was driven by computer program trading, and second, the bear market of 2022, which can be traced to the Fed’s aggressive series of rate hikes.

As we enter the last two months of the year, any number of factors could create unwanted volatility in the market. We know from experience that market pullbacks can occur at any time and when they are least expected.

Yet, the factors supporting stocks over the past year are still relevant.

The Ebb and Flow of Inflation

Let’s go granular and jump right into the numbers. Aided by a 1.9% decline in energy prices, the Consumer Price Index released by the U.S. Bureau of Labor Statistics (BLS) rose 0.2% in September. The annual rate slowed from 2.5% in August to 2.4% in September.

The core CPI accounts for 80% of the CPI per the U.S. BLS.  It excludes the more volatile food and energy categories. The core CPI rose 0.3% in September. The annual rate accelerated from 3.2% in August to 3.3% in September.

The headline rate is back below the core rate thanks to lower gasoline and oil prices.

While still elevated, note how much inflation has slowed since 2022—from an annual rate of 9.1% to 2.4% for the CPI. Core has been cut in half—from 6.6% to 3.3%. Yet, what economists call ‘the last mile (the return to 2% inflation)’ has been slow. At times, progress has nearly stalled. Let’s call them soft plateaus, as highlighted above.

What brought inflation down? Economists will be debating that question for years. Maybe it goes something like this.

For starters, inflation rose higher and longer than many had anticipated, forcing Fed Chief Powell to ditch his description that the early runup in prices would be “transitory.”

But then, the rate of inflation came down. In part, gasoline is no longer $5 per gallon. In part, inflation sort of really was transitory. But instead of a few months, transitory turned into a couple of years as gummed-up supply chains slowly righted themselves.

One thing we know for sure is that the economy can be shut down as easily as flipping a light switch. Turning it back on is a slow and tortuous process.

If a job-killing recession had occurred in 2023, economists would be saying that the Fed needed to create a recession to lower inflation, similar to the early 1980s. However, the much-predicted recession was a no-show. Unemployment remains low, and the economy continues to expand.

The inflation rate isn’t at the level of the last decade, but it has slowed down without a recession. And for investors, the slowdown helped greenlight a rate cut by the Fed. Meanwhile, modest economic growth supports corporate profits, which underpins stocks.